3 Rules for Trading Volatile Markets

For those who like to trade in the energy markets the last few weeks have been marked by one word: volatility. With 4 or 5 percent daily moves, and even larger intraday ranges, commonplace in oil futures it has been a period that, depending on your outlook and results, could be viewed as either terrifying or exhilarating. Despite that, most traders understand that volatility is ultimately your friend. Without movement there is no opportunity, and without opportunity there is no profit.

As welcome as volatility is, though, it can be an account killer to those unaware of how to handle it. During a long career in foreign exchange dealing rooms around the world I experienced extreme volatility many times and, almost without consciously doing so, developed a set of rules for dealing with it. As violent swings in WTI futures look to be set in for a while it is worth laying those rules out here.

Rule #1: Forget Your Long Term View

Most traders, and I am no exception, like to trade with a bias. That doesn't mean that I start every day with the same position. It just means that I am aware of the big picture influences of whatever I trade and, based on those fundamental factors, have an overarching, long term view. Right now, for example, I believe that this run up in oil will be short lived and that we need to test the lows again before a real recovery can take place. There is still oversupply, there are still worries about growth…essentially nothing has changed. That indicates that this is a short term trading move, not a fundamental shift; more of a squeeze than a reversal.

When it comes to intraday trading right now, however, I try to forget that each morning. Whether my long term, fundamental view is right or wrong, fundamentals are not what are driving the short term moves in oil futures. Market positioning and sentiment are far more important, and momentum is more powerful than ever. In an environment like this chart points take on an exaggerated importance. It is, therefore, essential, that you treat each trading day as separate and leave your preconceptions behind. Even if your fundamental analysis suggests a move lower you should be quite prepared to jump onto an upward move at any time.

Rule #2: Widen Your Brackets

Bracketing trades, that is to say placing a stop loss and take profit order for each position, is what most traders do. Over time, in normal markets, your perception of what is a reasonable distance from your entry point for those orders becomes pretty fixed. Those trading WTI futures, for example, might decide that roughly 20 points away from entry, depending on the chart, represents a reasonable stop loss, limiting potential losses to $200 per full contract or $100 per contract in the case of the NYMini futures that I prefer to trade.

When full on volatility hits, though, 20 points can disappear in a heartbeat and stops will be hit way too often. I don't mind taking a run of small, manageable losses but I don't want to put myself in the position where a loss is almost unavoidable unless my timing is perfect. To keep risk and reward in balance, that means that profit targets also have to be moved further away from the entry point; the whole bracket has to be stretched.

Widening brackets during periods of volatility is, when you sit back and think about it, just common sense but it is surprising how many traders have to take a whole bunch of losses before they start doing it. Moving to wider brackets at the first sign of increased volatility can therefore save a significant amount of pain.

Rule #3: Take Smaller Positions

This is another rule that seems blindingly obvious when you see it written, but often is learned by traders only through expensive experience. I was taught early on in my career that while traders are by nature optimists the smart ones base their decisions on the worst case scenario rather than the best. That means that rather than consider how much yummy profit you can make when things are flying around, the wise trader looks at the damage that can be done to an account.

From that perspective smaller positions are an obvious corollary to rule #2. If stop losses are further away then positions must be smaller to allow for that. If a regular 20 point potential loss becomes twice that, then halving the position size will, in theory, keep P&L swings about the same. The only problem with that is that volatile markets present opportunities at every turn, so traders tend to trade more. For that reason an even more drastic cut in position size is often warranted.

Understanding and adopting these three rules when things get choppy won't stop you losing money at times, nothing can do that. Losing trades are a part of trading; the trick is to limit the damage done when they come along and be sure to live to fight another day. Forgetting your long term view, widening your brackets and taking smaller positions will all help you to do that.